This past May, the Financial Accounting Standards Board (FASB) released the Statement of Financial Accounting Standards No. 150 Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity (SFAS 150). As a result, the balance sheets for many companies will change. SFAS 150 is the culmination of significant effort by the FASB, but only concludes a first phase of the FASB's redeliberation of its October 2000 Exposure Draft, Accounting for Financial Instruments with Characteristics of Liabilities, Equity or Both (the Exposure Draft).²

The FASB considers SFAS 150 a limited-scope statement. It provides guidance on certain freestanding financial instruments that should be classified as liabilities (although they may not be in current practice): (1) mandatorily redeemable instruments, (2) instruments embodying obligations (or indexed to obligations) to repurchase an issuer's equity shares by transferring assets and (3) certain instruments that the issuer must or can choose to settle with equity shares.

The FASB has not reached a determination on certain other issues embodied in the Exposure Draft, including separation of instruments with characteristics of both liabilities and equity into components, accounting for noncontrolling interests in consolidated subsidiaries, and the inclusion of ownership interest concepts in revised definitions of liabilities and equity.

Until now, issuers have classified certain financial instruments with characteristics of both liabilities and equity either entirely as equity or in a section on the balance sheet between the captions "total liabilities" and "equity" sometimes referred to as the "mezzanine." Under SFAS 150, the obligations affected will be accounted for as liabilities.

Financial Instruments Affected

SFAS 150 requires issuers to classify as liabilities (or assets in some circumstances³) three classes of freestanding financial instruments⁴ that embody obligations for the issuer.

Mandatorily Redeemable Financial Instruments. These instruments are those issued in the form of shares that include an unconditional obligation for the issuer to redeem the instrument by transferring cash or other assets to the holder at a specified date or upon the occurrence of an event. The most common of these is mandatorily redeemable preferred stock. Current practice classifies these securities in the mezzanine. SFAS 150 eliminates this accounting and requires issuers to classify these securities as liabilities.

Some of these securities may embody a conditional obligation to redeem. In those cases, the securities would be classified as equity until such time as the event that is conditional occurs or the event becomes certain to occur. When the condition is resolved, the security would be reclassified from equity to debt. (SFAS 150 notes that securities for which the obligation to redeem is conditioned on the death of the holder are liabilities at issuance. This follows the old rubric that the only certainties in life are death and taxes.)

Obligations to Repurchase the Issuer's Equity Shares by Transferring Assets. Financial instruments such as forward-purchase contracts, or written put options on the issuer's equity shares that are to be physically settled or net-cash settled, are to be classified as liabilities if at inception the financial instrument contains an obligation to repurchase the issuer's equity shares (or is indexed to such an obligation) and requires the issuer to transfer cash or other assets to settle the obligation.

Certain Obligations to Issue a Variable Number of Shares. Financial instruments where the issuer must or may settle the unconditional obligation by issuing a variable number of the issuer's equity shares (rather than cash or other assets) are to be classified as liabilities if the monetary value of the obligation is predominantly based on either (a) a fixed monetary amount known at inception, (b) variations in something other than the fair value of the issuer's equity shares or (c) variations inversely related to changes in the fair value of the issuer's equity shares.

Implementation and Impact on Financial Reporting

SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003. The statement is otherwise effective at the beginning of the first interim reporting period beginning after June 15, 2003.⁵ Accordingly, users of financial statements will begin to see changes with the issuance of third-quarter statements in mid-October.

As previously noted, the financial instruments affected by SFAS 150 will be classified as liabilities. The provisions of SFAS 150 will be applied to those financial instruments outstanding at the beginning of the interim period of adoption by reporting the cumulative effect of a change in accounting principle, initially measuring the financial instruments at fair value or other measurement attributes required by SFAS 150. SFAS 150 prohibits restatement of financial statements for earlier periods presented by an issuer.

Among other areas affected by the implementation of SFAS 150 will be the reporting of dividends, interest expense and earnings per share. Items previously reported as dividends will be reported as interest expenses, as may certain changes in fair value of the financial instruments subsequent to initial valuation.

Already, in the "Recently Issued Accounting Standards" section of their most recent quarterly reporting since the release of SFAS 150, many companies have indicated the application of SFAS 150 to financial instruments on their balance sheets. Some, such as Sara Lee Corp. in its May 29, 2003, Form 8K, have provided detailed disclosure on how SFAS 150 will affect $295 million of preferred equity securities issued by a foreign subsidiary and currently classified as "minority interest in subsidiaries." First Tennessee National Corp., in its July 7, 2003, press release, has signaled that the implementation of SFAS 150 will impact its net interest margin because of the new treatment the expense associated with its trust-preferred and REIT-preferred securities will receive when the statement is adopted in the third quarter. Previously these costs were considered non-interest expenses. And others, such as EaglePicher Holdings Inc. and American Skiing Co., while currently presenting financial instruments in the mezzanine, do not anticipate that the implementation of SFAS 150 will have any material impact on their financial condition or results of operations.

Disclosures

SFAS 150 requires the following disclosures.

1. The nature and terms of the financial instruments within the scope of SFAS 150 including:
   • the rights and obligations embodied in those instruments;
   • information about the settlement alternatives, if any; and
   • identity of the entity that controls the settlement alternatives.
2. For all financial instruments within the scope of SFAS 150, and for each settlement alternative:
   • the amount that would be paid or the number of shares that would be issued and fair value if the settlement had occurred on the reporting date;
   • how changes in the fair value of the issuer's equity securities would affect those settlement amounts;
   • the maximum amount the issuer would be required to pay to redeem the instrument by physical settlement, if applicable;
   • the maximum number of shares that could be issued, if applicable;
   • if applicable, that the contract does not limit the amount that the issuer would be required to pay or the number of shares the issuer could be required to issue; and
   • for a forward contract or an option indexed to the issuer's equity shares, the forward price or option strike price, the number of shares to which the contract is indexed and the settlement date or dates of the contract, as applicable.

Conclusion

SFAS 150 resolves certain questions of balance-sheet "geography" between the classification of debt and equity providing a framework for determining the status of the financial instruments within its scope. With companies implementing SFAS 150 in the third quarter of 2003 and early 2004, financial statement analysts and other financial statements users must be alert to evaluate the statement of operations and balance-sheet impact of the implementation on their analyses. Unless already considered, the changes required by SFAS 150 may impact compliance with lending agreements and covenants as financial instruments move from the mezzanine or equity to liabilities.

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Footnotes

¹ James M. Lukenda is a managing director in Huron Consulting Group's Corporate Advisory Services practice. The current president of the Association of Insolvency and Restructuring Advisors, he has wide experience in accounting, financial and operating matters related to corporate reorganizations. Return to article

² See Lukenda, James M., "New Standards for Distinguishing Between Liabilities and Equity May Be Close at Hand," ABI Journal, Vol. XIX, No. 8, October 2000. Return to article

³ Some instruments that have characteristics of both debt and equity, in some circumstances, also have characteristics of assets. An example provided in SFAS 150 is a forward contract to purchase the issuer's equity securities that is to be net cash settled. Return to article

⁴ A freestanding obligation is "a financial instrument that is entered into separately and apart from the entity's other financial instruments or equity transactions, or that is entered into in conjunction with some other transaction and is legally detachable and separately exercisable (SFAS 150, Appendix D)." Return to article

⁵ The effective date for mandatorily redeemable financial instruments of nonpublic entities is the fiscal period beginning after Dec. 15, 2003. Return to article